Have central banks lost their superpowers?

Ahead of the European Central Bank’s (ECB) meeting on 10 March we look at whether central banks’ powers are waning in their fight against falling inflation.

08/03/2016

Harvinder Gill

Economist

Is the ECB running out of ammunition?

For policymakers to maintain credibility, some argue it is time for something from outside the box.

Ahead of the March ECB meeting, three factors have set the scene for potential further policy easing:

Lower oil prices

Fears over global growth

Lower market based measures of inflation expectations

One may expect similar policy responses of rate cuts or quantitative easing (QE) expansion to not produce vastly different medium term results to what we have seen already, with growth and inflation so far limited in the backdrop of subdued global growth.

It is perhaps this thought process that leaves the market questioning what effective policies central banks can enact further.

Admitting defeat to persistently weak inflation may entail a lowering of inflation targets across the globe, something we have not yet witnessed.

In particular, ECB President Mario Draghi has been vocal in being unwilling to “surrender” to low inflation.

Is the central bank "put" still effective?

For at least the last decade the general belief within markets is that regardless of the situation, central banks will help limit losses in risk assets by lowering interest rates or introducing QE (also known as the central bank ‘put’ option).

This school of thought has been questioned in recent weeks, with further possible policy action available to central banks seemingly limited, at least compared to what was available in the past.

Monetary policy has been kept very loose, yet signs of strong growth and inflation are difficult to see.

A prime example of this can be seen in the US. The first chart illustrates that the lower interest rates are in the economy (3-month US government bond yields used as a proxy) relative to nominal GDP growth, the looser monetary policy is defined as being.

As shown in the second chart, inflation has tended to pick up a couple of years after the initiation of loose monetary policy.

This has not been the case in the most recent cycle. Instead, asset price inflation has occurred, with equity markets and house prices rising, no doubt spurred on by QE.

The most recent fall in inflation has arguably been due to a series of supply side shocks though, which therefore may be masking the core inflationary pressures within the global economy.

Will falling inflation become a self-fulfilling prophecy?

However, it is the second round effects of these supply-side shocks that are feared by European policy makers in particular, with lower spot inflation used in setting future wages and prices, thus affecting core inflation.

The problem with inflation is the longer it stays low, the more embedded lower long-term inflation expectations become.

This seems to not be only a European problem though, with market-based measures of average inflation in the 6-10 year range falling across many major markets.

Consumer-based expectations of inflation have also been falling in recent years, with the University of Michigan 5-year inflation expectation survey illustrating this in the third chart.

Can Draghi deliver?

Expectations have been trending down since 2011, with current levels near all-time lows (although still well above the 2% inflation target).

With inflation, or the lack of it, a hot topic for investors focus will inevitably fall on Mario Draghi and the ECB meeting.

The market had previously nicknamed the ECB President ‘Super’ Mario Draghi after the “shock and awe” asset purchasing programme announced in January 2015.

On 10 March we will find out whether that nickname has been reclaimed after the disappointment of the December meeting.

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